British Airways plc, the U.K.'s money-losing flag carrier, may be flying a little higher this week as it edges closer to approval for an alliance with American Airlines Inc. But it still has to deal with turbulence from its employee unions and a £3.7 billion ($5.8 billion) pension scheme deficit that could disrupt its long-planned merger with Spanish airline Iberia Lineas Aéreas de España SA.

Northfield, Ill., food group Kraft Foods Inc. might be enjoying the sweet taste of victory as British chocolate maker Cadbury plc finally melts into its £11.7 billion embrace. But the trustees of Cadbury's 105-year-old pension fund have served notice that they plan to hang tough over commitments to close its £480 million deficit.

More worrying still: The scheme is due for a triennial review in April, and the deficit may turn out to be much higher, taking into account changes in the value of the fund's assets and liabilities.

Meanwhile, to add to its other debt woes, EMI Group Ltd., the troubled music group owned by private equity house Terra Firma Capital Partners Ltd., is still wrangling with its pension fund trustees. At the last triennial review in 2008, the deficit stood at between £10 million and £200 million.

A recent report from Maltby Ltd., Terra Firma's holding company for EMI, warned that if the company were forced to make additional contributions to the retirement plan before it reached agreement with Citigroup Inc. over its buyout debt of £2.6 billion, then "funding for these contributions ... [would] need to be met by additional funds from the shareholders." There was no certainty, it added, that such funds would be available.

These are hardly isolated cases. Corporate sponsorship of a pension fund has to be renegotiated both after a change of control and following every triennial review. Europe's biggest buyout, the £12.1 billion take-private of Alliance Boots plc by Kohlberg Kravis Roberts & Co. and Stefano Pessina in 2007, involved a £1 billion settlement thrashed out with the trustees of the retirement scheme.

Under the terms of the pact, the company would pay in an additional £468 million over 10 years and guarantee that a further £600 million of potential underfunding would rank among the company's senior creditors.

The compromise agreement secured regulatory clearance and should have taken risk out of the deal. This summer, however, when the scheme has its triennial review, pension analysts expect the deficit to have grown, due to falling bond yields, weaker equity prices and changed accounting assumptions.

As a result, the trustees will have a fiduciary duty to their members to come back and ask for more funds to be injected. Under British rules, the Pensions Regulator has the right to intervene if it regards the settlement as unfair to pensioners or too risky.

Theoretically, the Pensions Regulator has powers to force parent companies or related persons -- including private equity sponsors or financial investors with control of more than 33% of the company -- to top up future deficits. The regulator can even impose contributions up to six years after the financial sponsor has exited its investment.

Just how tough will the Pensions Regulator be in practice? In 2008, private equity shop Duke Street General Partner Ltd. decided to make a £12 million contribution to the pension fund at Focus (DIY) Ltd., a debt-laden home improvement company that Duke Street and Apax Partners had sold to Cerberus Capital Management LP the previous year, for a token £1. The regulator had opened an investigation into the deal after a tip-off by a whistleblower. Duke Street preferred to make a voluntary contribution to the retirement fund rather than wait for the regulator to present a public -- and likely more expensive -- directive to prop up the plan.

Reader's Digest Association Inc. on Feb. 17 pushed its U.K. subsidiary into bankruptcy administration after the regulator declined to approve a pension fund agreement that it judged to be inadequate.

The decision will allow the U.S. publisher to leave Chapter 11 bankruptcy but will leave its U.K. pensioners with limited payouts from the U.K. government-administered Pension Protection Fund. That's ultimately paid for via a risk-based levy on all defined benefit schemes. Yet exercising draconian powers is a last resort, and the regulator would normally try to work with both the company and the trustees. BT Group plc recently revealed the country's largest pension deficit to date. But the telecom said it had reached agreement with the retirement fund's trustees to address the £9.4 billion deficit with an agreement to increase its annual cash contribution to £525 million and £533 million a year for the following 14 years, to cut the shortfall by £6 billion. But the regulator said it still had substantial concerns, apparently over the 17-year timetable.

Inevitably, the rules are taking a toll on mergers and acquisitions -- and particularly on private equity deals. The greater the leverage on a balance sheet, the greater the risk to free cash flow and to a company's ability to fund a pension scheme. As far back as 2007, pension scheme risk helped abort two successive £12 billion bids for supermarket chain J Sainsbury plc. But in 2006 and early 2007, at the height of the buyout bubble, the level of due diligence on company pension schemes was more often relatively low. People did their deals and thought about the pension deficit only when the trustees came knocking at their door.

Nowadays, as cash flows decline, pension schemes appear increasingly underfunded and buyers are more aware, the risk is being factored into the price of the deal.

The deals will still happen but not at any price.

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